Diversified sources of risk and return are essential for every investor, and hedge funds have historically played an important role in achieving this goal. While hedge funds have continued to offer diversification in recent years, there has been significant dispersion in manager performance. What can investors do to seek consistency of diversification and performance?

We suggest that investors consider alternative risk premia strategies. We
estimate that roughly a third of the total risk across a broad sample of
hedge fundsi is driven by traditional or alternative risk
premia. However, risk premia can be accessed at much lower cost and with
higher liquidity. We believe investors can get more from their hedge fund
allocation by selectively replacing part of their portfolio with exposures
to alternative risk premia.

Revisiting recent hedge fund performance

The broad hedge fund universe returned 3.8% annualized over the seven years ended December 2016, compared to the 7.9% return from global equities and the 4.0% return from fixed income (see Figure 1). The difference in performance versus equities should not be surprising: Strategies designed to diversify away from equities are not likely to fare well during a strong equity bull market. Furthermore, unprecedented central bank intervention over this period has suppressed volatility in financial markets, creating a challenging environment for strategies designed to capitalize on market dislocations.

There has also been a high degree of dispersion in performance among hedge
funds, as shown in Figure 1. Top-quartile hedge fund managers in our broad
sample delivered an annualized return of 9.2%, handily outperforming the
median hedge fund manager by 3.5 percentage points per annum. The top
performers (95th percentile) delivered 17.1% in annualized return,
outperforming peers and the broad market by an even wider margin. This
highlights the importance of manager selection. However, while everyone
desires an allocation to star performers, finding them on a consistent
basis is challenging. Some of the top funds are capacity-constrained and
thus closed to new investors.

Critically, investors evaluating hedge fund allocations shouldn’t focus
solely on the level of performance versus traditional assets, as is often
the case. They should also look at where the performance comes
from. A truly diversifying asset can be useful in portfolio construction
even if its stand-alone returns are lower than or similar to those of
traditional asset classes.

Typically, investors in hedge funds expect little exposure to traditional
and alternative risk premia because these can be accessed elsewhere at much
lower cost. Ideally, investors want most hedge fund risk to be driven by
alpha – as we strive to do in all discretionary PIMCO hedge funds – as this
produces idiosyncratic risk, which tends to have low or negative
correlations with other assets, and amplifies the diversification benefits
investors seek. However, it is important to note that diversification does
not ensure against loss.

Evaluating sources of hedge fund manager risk

The key drivers of return and risk within hedge funds can be estimated
through quantitative analysis. Multiple regression can be a powerful tool
in uncovering whether a hedge fund manager has systematic exposures to
traditional or alternative risk premia, which in turn may reveal a
conscious or unconscious style bias in the manager’s process.

To illustrate this point, let’s look at the risk profiles of two
hypothetical managers (see Figure 4):

While both managers delivered identical returns with the same level of
volatility, the sources of those returns varied markedly. Only 20% of
manager A’s risk can be explained by exposures to traditional and
alternative risk premia. In contrast, at 80%, manager B’s risk profile
reflects significant exposures to risk premia. So even though both managers
delivered the same return at the same risk level, an allocation to manager
A would have been superior from a portfolio diversification perspective
because most of the risk is driven by idiosyncratic sources.

In assessing a hedge fund manager’s real “value add,” then, another
benchmark could be helpful: one that excludes returns attributable to
traditional and alternative risk premia. If alpha is negative relative to
this benchmark, an investor may want to consider whether the investment
results are consistent with the manager’s investment proposition. In
particular, hedge funds billed as market-neutral or relative-value should
produce returns primarily through idiosyncratic risk sources.

This analysis is critical from a diversification perspective. Given that
most investors hold significant exposures to traditional risk premia in
other parts of their portfolios, overlapping exposures within the hedge
fund allocation may reduce overall portfolio diversification.

Evaluating manager performance

We used a multi-factor regression analysis to evaluate the persistence of
common risk-factor exposures among 300 of the largest hedge fund managers.
This sample included managers within eight different strategy cohorts with
at least $250 million in assets under management (AUM) and seven years of
performance history as of September 2016 (based on data from Eurekahedge).

Our analysis produced three key takeaways. First, many hedge funds have
meaningful exposure to traditional risk premia. In particular, equity risk,
which tends to dominate most investor portfolios, accounted for a
substantial portion of the risk in certain categories, with significant
variation within most categories. (See Figure 5).

Second, on average, common risk premia explained one-third of the risk. Their prevalence varied by category, ranging from 25% for relative-value hedge fund strategies to 41% for CTAs (commodity trading advisors), which tend to have systematic exposures to the momentum factor.

Finally, there is significant variation in exposures to traditional and alternative risk premia among managers in the same category. Consider the “macro” strategy category, where risk premia explain anywhere from 4% to 96% of manager risk. While the heterogeneous nature of strategy implementation may be partially responsible, the wide range also reveals the importance of not relying simply on category-level diversification when constructing a hedge fund portfolio. Instead, it is critical to evaluate each manager’s sources of risk and return to ensure they are in line with expectations (see Figure 7).

Impact on portfolio efficiency

Our analysis highlights three criteria that investors can use to
evaluate the cost and effectiveness of hedge fund allocations:

Are there persistent exposures that are inconsistent with a manager’s
stated investment style (i.e., style drift)?

Persistent exposure to traditional risk premia, such as equities, is likely
to reduce the diversification benefits of the investment. Given that
traditional risk premia already account for the bulk of risk in most
portfolios, investors may want to avoid managers who have sizeable
exposures, especially if alpha makes zero, or worse, a negative
contribution to overall returns.

In contrast, exposure to alternative risk premia may offer a complementary
source of return and attractive diversification benefits to a broader
portfolio. However, investors may be best served by allocating directly to
systematic alternative risk premia strategies rather than to discretionary
hedge strategies. Several dedicated alternative risk premia strategies
offer greater liquidity and lower fees.

Finally, investors should ensure that a hedge fund manager’s risk profile
is commensurate with the stated investment style. For example, an equity
market-neutral strategy should not have a significant proportion of risk
explained by equity beta.

In conclusion, risk premia account for at least 50% of the risk in about
one-quarter of the typical hedge funds in our sample. Therefore, we believe
investors have ample room to increase portfolio efficiency by replacing
certain managers and allocating to more cost-effective strategies.

iData from Eurekahedge (12/31/2009 to 12/31/2016). Funds are selected based on data availability for the period. We have included all funds with a minimum $250 million in AUM, where performance is reported for each month during the sample period, and which fall into one of the following eight primary strategy categories: Arbitrage, CTA/Managed futures, Event-driven, Fixed income, Long/Short equities, Macro, Multi-Strategy and Relative value.

Summary

With low yields and mature valuations across traditional assets, investors are exploring ways to increase diversification without sacrificing returns.

Hedge funds have historically served this role, but significant dispersion in manager performance has caused many investors to seek other diversifiers to complement their hedge fund allocations.

Disclosures

A word about risk:

Past performance is not a guarantee or a reliable indicator of future
results.
All investments
contain risk and may lose value. Managed futures contain
heightened risk, including wide price fluctuations and may not be suitable
for all investors. Investing in the bond market is subject
to risks, including market, interest rate, issuer, credit, inflation risk,
and liquidity risk. The value of most bonds and bond strategies are
impacted by changes in interest rates. Bonds and bond strategies with
longer durations tend to be more sensitive and volatile than those with
shorter durations; bond prices generally fall as interest rates rise, and
the current low interest rate environment increases this risk. Current
reductions in bond counterparty capacity may contribute to decreased market
liquidity and increased price volatility. Bond investments may be worth
more or less than the original cost when redeemed. The strategy will seek
exposure to commodities through commodity-linked derivatives. Commodities contain heightened risk including market,
political, regulatory, and natural conditions, and may not be suitable for
all investors. Derivatives and commodity-linked derivatives may involve
certain costs and risks such as liquidity, interest rate, market, credit,
management and the risk that a position could not be closed when most
advantageous. Commodity-linked derivative instruments may involve
additional costs and risks such as changes in commodity index volatility or
factors affecting a particular industry or commodity, such as drought,
floods, weather, livestock disease, embargoes, tariffs and international
economic, political and regulatory developments. Investing in derivatives
could lose more than the amount invested. High yield, lower-rated securities involve greater risk
than higher-rated securities; portfolios that invest in them may be subject
to greater levels of credit and liquidity risk than portfolios that do not.
Investing in foreign denominated and/or domiciled securities may
involve heightened risk due to currency fluctuations, and economic and
political risks, which may be enhanced in emerging markets. The models
evaluate securities or securities markets based on certain assumptions
concerning the interplay of market factors. Models used
may not adequately take into account certain factors, may not perform as
intended, and may result in a decline in the value of your investment,
which could be substantial.

Hypothetical examples are for illustrative purposes only. Hypothetical and
simulated examples have many inherent limitations and are generally
prepared with the benefit of hindsight. There are frequently sharp
differences between simulated results and the actual results. There are
numerous factors related to the markets in general or the implementation of
any specific investment strategy, which cannot be fully accounted for in
the preparation of simulated results and all of which can adversely affect
actual results. No guarantee is being made that the stated results will be
achieved. There is no guarantee that these investment strategies will work
under all market conditions or are suitable for all investors and each
investor should evaluate their ability to invest long-term, especially
during periods of downturn in the market.